Dollar strong now, lackluster later

After pronounced weakness in 2017, the U.S. dollar (USD) has made a spectacular comeback this year. A widening interest rate advantage over other developed-market currencies could keep it strong in early 2019, and many investors are already positioned for a continued dollar bull market.


In the currency markets, attention is now shifting to the Fed outlook for 2019. Over recent weeks, Fed officials have generally conveyed a steady message pointing to three to four rate hikes for 2019, which is in line with our own view. In contrast, the Fed Funds futures as of December 2018 have priced less than two hikes. We think the continuing divergence between our team’s Fed call and market pricing warrants a stronger dollar in the short term. As we show in the chart below, the growing difference in 2-year interest rates between the U.S. and the G9 countries1 has been a tailwind for the U.S. Dollar Index (DXY) throughout 2018.

However, we believe investors should not try ride the dollar wave with too much enthusiasm. First, the greenback has become more expensively valued. As of October 2018, the trade-weighted and inflation-adjusted U.S. dollar exchange rate calculated by the Bank of International Settlements stands around 14% above its average since 1990.

Secondly, we have long argued that a stretched net long position in USD index futures could be an impediment to a sustained U.S. dollar rally. As of November 22, the Commodities and Futures Trade Commission’s data shows a speculative net long in the U.S. Dollar Index futures at 69% of open interest. This is in the 99th percentile of observations, which means in only 1% of months has the net long position been at that level or higher.

Looking at the historical performance of the USD index when positions reach such extremes, we find they are not very predictive in the near term (1-3 months) but imply negative average returns over a 12-month horizon with a hit rate of 73%. Our analysis suggests that positioning does not stand in the way of a stable or stronger dollar in the near term, but it is a big obstacle over a 12-month horizon.

Other major currencies

Euro (EUR)
We see the euro outlook as almost the mirror image of U.S. dollar prospects. In the short term (over the next three months), the budget standoff between Italy and the European Commission is a significant headwind. However, we expect a compromise to emerge that should allow the euro to recover during the course of 2019.

U.K. pound sterling (GBP)
The 29th of March 2019 looms large as the date when the U.K. is due to leave the European Union (EU). While the British government has been able to agree to a deal with the EU that secures the terms of exit and a 20-month transition period, its passage through parliament is not certain at all. Sterling could suffer if the parliamentary Brexit vote fails. We do not expect the deal to pass at the first attempt, but to be followed by another Commons vote or even a second referendum that helps to avoid a no-deal Brexit. Sterling could then rally from a lower level toward its fair value of 1.40 against the dollar.

Japanese yen (JPY)
Long Japanese yen is our highest-conviction currency view. Attractive valuation and its defensive characteristics make it our preferred G10 currency in 2019 when it could be a helpful diversifier during periods when risky assets sell off.

Emerging Market (EM) currencies
Most EM currencies have been battered at some point or another this year amid a noxious blend of strong dollar, rising global bond yields and country-specific crises. Argentina and Turkey are the “basket cases” for countries that have inflicted pain on themselves through loose economic policies and the build-up of macroeconomic imbalances. The escalating trade war between the U.S. and China has dragged down the currencies of Asian economies that compete with China and are tightly linked to global manufacturing supply chains.

The good news is that EM currencies have fallen to attractive valuation levels, in our view. In the chart below, we plot the valuation score for two EM currency baskets, one weighted according to the MSCI Emerging Markets Index, the other according to the JP Morgan Government Bond Index-Emerging Markets. Our proprietary valuation indicator flags both EM currency baskets as very cheap vis-à-vis the U.S. dollar. This valuation buffer may partly explain why EM currencies held up well during the stock market sell-off in October and November. We are encouraged by the resilience and stick with our cautiously optimistic attitude toward EM currencies.

1The G9 currencies are the G10 excluding the U.S. dollar and comprise the Australian dollar, Canadian dollar, Swiss franc, euro, U.K. pound, Japanese yen, New Zealand dollar, Norwegian kroner and Swedish krona.

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